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Derivatives: Practical Issues in Implementing the Standard Eric S. Berman, MSA, CPA Deputy Comptroller Commonwealth of Massachusetts June 27, 2007

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One Investors View Charlie [Munger, Buffett's partner in managing Berkshire Hathaway] and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.

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Additional Buffetisms The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in No problem--at a price, you will easily find an obliging counterparty.

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Additional Buffetisms Like Hell, [derivatives] are easy to enter and almost impossible to exit. In [derivatives], once you write a contract--which may require a large payment decades later-- you are usually stuck with it. True, there are methods by which the risk can be laid off with others. But most strategies of that kind leave you with residual liability.

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Agenda for Today Common Definitions Types of Derivatives Preparers and Auditors Encounter Why Do Derivatives? - Hedging

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What Are Derivatives? A Derivative is an instrument (financial or otherwise) whose value depends on the value of an underlying variable. What does it mean to you? What is the point of entering into a Derivative contract?

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Derivatives in other words The definition of a derivative itself is a financial instrument or other contract with all three of the following characteristics: It has (i) one or more reference rates and (ii) one or more notional amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.

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Derivatives in other words It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts expected to have a similar response to changes in market factors.

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Derivatives in other words Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

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Derivatives Notional amounts outstanding, 1987-present Source: International Swaps and Derivatives Association, Inc., 2007 $327.3 trillion in 2006

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Common Definitions to Know Underlyings are the unrelated assets that are used to gauge the value of the derivative. The value of the derivative is the value of the underlying times a notional quantity. The notional rate is the current, floating interest rate applied to bonds

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Common Definitions to Know A hedge is a contract entered into to reduce some form of risk. Hedges that accomplish the goal of reducing risk as expected are commonly referred to as effective.

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Common Definitions to Know A cap is where parties enter into an agreement in exchange for a premium in order to limit interest rate risk. Can you describe a common cap? Cashflow hedges use cash inflows based on periodic interest rates Collars limit interest rate exposure to a specified range in the contract.

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Common Definitions to Know Compound derivatives are where an entity enters into multiple derivatives within the same contract. Synthetic Derivatives Credit derivatives or risk swaps are contracts where two parties join to insure a third partys debt issuance. A currency swap is where parties exchange specific amounts of foreign currencies at the time of contract and repay each other at specified intervals and at rates based on fixed interest rates in each currency.

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Common Definitions to Know Fair value hedge – A derivative instrument that offsets fair value changes in hedgable items Forward - A forward contract gives the owner the right and obligation to buy a specified asset on a specified date at a specified price. The seller of the forward contract has the right and obligation to sell the asset on the date for the price.

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Common Definitions to Know Forwards – Continued Generally, no money changes hands on the origination date of the forward contract. However, collateral may be demanded. Delivery options may exist concerning the quality of the asset the quantity of the asset the delivery date the delivery location. If your position has value, you face the risk that your counterparty will default.

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Common Definitions to Know Floater is another term for variable rate interest debt Future - An option to purchase or sell a commodity, instrument, asset, liability, index or other item at a specific time in the future. Interest Rate Swap Swaption

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Types of Derivatives that Accountants Encounter % of notional amounts outstanding – as of June 2006 – Source Bank for International Settlements

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Types of Derivatives that Preparers and Auditors Encounter Swaps The MOST prevalent derivative in the market A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions. A swap is equivalent to a coupon- bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating.

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Types of Derivatives that Preparers and Auditors Encounter Swaps – Example An Investment Bank agrees to pay a fixed payment and receive a floating payment, from a Government. Investment Bank is the fixed rate payer- floating rate receiver (the pay-fixed party). Government is the fixed rate receiver- floating rate payer (the receive-fixed party). Typically, there is no initial exchange of principal (i.e., no cash flow at the initiation of the swap).

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Plain Vanilla Swap On 3/1/xx, an agreement is struck wherein for the next 3 years, every six months, Investment Bank receives from Government, a payment on a notional principal of $100 million, based on the 6 month LIBOR rate. Investment Bank makes a fixed payment on the same notional principal to Government, based on a rate of 5.75% per annum. You need to know the fixed rate. You need to know the variable (floating) rate. You need to know notional principal. Note that 6-month LIBOR at origination is R 0 = 5.36%. The next two slides illustrate the cash flows.

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Each actual payment (difference check) equals the difference between the interest rates times NP times #days between payments over 360, or #days/365. The time t variable cash flow is typically based on the time t-1 (this period minus 1) floating interest rate. Thus, the first floating cash flow, based on the rate, R 0, is known: it is 5.36%. All subsequent floating cash flows are random variables as of time zero (but always known one period in advance). 0 Multiply each R by NP times #days between payments over 360 (or use a 365-day year) How to Calculate the swap

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Millions of Dollars LIBORFLOATINGFIXEDNet DateRateCash Flow Mar.1, 200x5.36% Sept. 1, 200x5.4%+2.68–2.875–0.195 Mar.1, 200y5.1%+2.70–2.875–0.175 Sept. 1, 200y5.2%+2.05– Mar.1, 200z5.3%+2.60– Sept. 1, 200z5.4%+2.15– Mar.1, 20aa5.1%+2.70– The Cash Flows to Investment Bank from Government

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A Closer Look at the Cash Flows on September 1, 200x Floating Payment: Based on the 6-month LIBOR rate that existed on March 1, 200x: 5.36%. ($100,000,000)(0.0536)(1/2) = +$2,680,000. Fixed Payment: Based on 5.75% rate. ($100,000,000)(0.0575)(1/2) = -$2,875,000. Net Cash Flow: -$195,000.

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Plain Vanilla Swap involving a government that issues bonds Why did this government enter into this transaction??? INVESTMENT BANK GOVERNMENT BONDHOLDER 5.75% 6 month LIBOR 5.36% 5.75% Pays Receives Pays Receives

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What Preparers need to worry about Similar items already being done for Fair values of Derivatives need to be as of Statement of Net Assets date If derivatives are tied to Business Type Activities – good idea to segregate swap revenues from debt expense Non-debt related derivatives may be out there

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What Preparers need to worry about Disclosure Items Summary of activity during the period by category: fair value hedges, cash flow hedges and investments Within category, segregate by type (swaps, caps, swaptions, futures, etc.) Similar disclosure to TB

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Evel Knievels Foray into Derivatives and Hedging – September 8, 1974

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Why Do Derivatives? How did Evel Hedge Risk? Two ways to view Risk Some Investors want to Increase risk to increase potential return Some Issuers want to decrease risk to fix costs

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The Goals of Risk Financial goal – reduce the variability of cash flows, though can never eliminate it Prices are volatile!

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Governments are Generally Risk Averse Reasoning: Managers are risk averse – why? Bondholders are risk averse – why? Stakeholders (i.e., employees, suppliers, customers) are risk averse – why? So, a reduction in risk should benefit everyone. Plus, a decrease in volatility implies a lower cost of finance, and therefore, an increase in net assets. Risk aversion: a willingness to pay a premium to reduce risk exposure.

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4 Basic Risks Hedging Attempts to Cure Market Risk (including prices and interest rates) Credit Risk Probability of default Depth of exposure Method of recovery (cure) Basis Risk (a.k.a. spread) Rollover or termination risk

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Key to Hedge Success – Is it Effective? Hedge effectiveness is somewhat in the eye of the beholder, but can be calculated The opposite of an effective hedge is???

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Keys to Effectiveness General requirements are the following: Management intends and documents its strategy to reduce risk Offsetting occurs consistently If cash flow hedge, highly probable Measurement can reasonably occur Measurement is ongoing and effectiveness is determined throughout the financial reporting period

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Keys to Effectiveness Methods to evaluate include Qualitative Are terms in debt and derivative consistent (consistent critical terms method) Quantitative Methods Synthetic instruments method Dollar offset method Regression analysis method

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What Preparers Need to Worry About - Hedges Hedge Effectiveness Calculation Disclosure Why hedge was entered into Terms Notional Amounts, Rates, Terms, Options and cash paid or received Risks (Similar to TB ) Method for determining effectiveness

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However, Hedges have Risks

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